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March 2012 Hedge Fund Report - Summary of Key Developments - Spring 2012 BY THE INVESTMENT MANAGEMENT, SECURITIES LITIGATION & TAX PRACTICES This continues to be a time of rapid change for the hedge fund industry, as the Securities and Exchange Commission (the “SEC”), the Commodity Futures Trading Commission (the “CFTC”), and various other regulatory agencies, including the Federal Reserve Board (the “Federal Reserve”) and the Department of the Treasury (the “Treasury”), continue to propose and finalize rules to implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). There have also been a number of significant developments in the hedge fund tax area, and the SEC and private plaintiffs have continued to bring enforcement actions and litigation involving hedge funds and other types of private investment funds and fund managers. This Report provides an update since our last Hedge Fund Report in November 2011 and highlights recent regulatory and tax developments, as well as recent civil litigation and enforcement actions as they relate to the hedge fund industry. Paul Hastings attorneys are available to answer your questions on these and any other developments affecting hedge funds and their investors and advisers. I. SECURITIES-RELATED LEGISLATION AND REGULATION ...........................................................................2 A. Dodd-Frank Rulemaking.................................................................................................................2 B. Other New and Proposed Securities-Related Legislation and Regulation................................................5 C. Other Updates...............................................................................................................................7 II. TAXATION...........................................................................................................................................9 A. White House Budget Proposal..........................................................................................................9 B. Carried Interest Legislation........................................................................................................... 10 C. Capital Gains Rates Set to Rise...................................................................................................... 10 D. Recent Foreign Account Tax Compliance Act Developments............................................................... 10 E. Recent FBAR Developments.......................................................................................................... 11 F. New Reporting Requirement for Individuals with Foreign Financial Assets ........................................... 12 G. IRS Releases Guidance on Providing Schedules K-1 Electronically to Recipients................................... 15 H. Proposed New York City Audit Position............................................................................................ 15 III. CIVIL LITIGATION.............................................................................................................................. 16 A. Update on Previously Reported Cases............................................................................................. 16 1 B. New Developments in Securities Litigation...................................................................................... 16 IV. REGULATORY ENFORCEMENT .............................................................................................................. 19 A. Insider Trading............................................................................................................................ 19 B. Expert Network Firms................................................................................................................... 20 C. Valuation of Illiquid Assets............................................................................................................ 23 D. Ponzi Schemes............................................................................................................................ 24 E. Fraudulent Misrepresentations....................................................................................................... 26 I. SECURITIES-RELATED LEGISLATION AND REGULATION A. Dodd-Frank Rulemaking The following is the status of various proposed and final rules and regulations implementing the Dodd-Frank Act that are most relevant to the hedge fund industry. 1. SEC and other Financial Regulators’ Extension of the Comment Period on the Jointly Proposed Volcker Rule On December 23, 2011, the SEC, jointly with the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Federal Reserve (collectively, the “Agencies”) issued a notice extending the comment period for their jointly proposed rule implementing Section 619 of the Dodd-Frank Act, also known as the “Volcker Rule.” On February 14, 2012, the CFTC also issued a proposal for implementing the Volcker Rule separate from the Agencies which adopts the entire text of the Agencies’ proposed rule and adds additional CFTC-specific rule text. More information on the CFTC’s proposed rule is available here. The Volcker Rule generally prohibits a banking entity from (i) engaging in short-term proprietary trading of any security, derivative, and certain other financial instruments for the banking entity’s own account; or (ii) owning, sponsoring, or having certain relationships with a hedge fund or private equity fund. The Agencies received more than 14,000 comments since they proposed the rule implementing the Volcker Rule on October 12, 2011. The proposed regulations have garnered significant criticism from the financial industry, primarily on the grounds that the Rule is overbroad and would reduce liquidity in the markets. Due to the complexity of the issues involved and to facilitate coordination of the rulemaking among the Agencies, the Agencies extended the comment period 30 days until February 13, 2012. The deadline for comments on the CFTC’s proposed Volcker Rule is April 16, 2012. Additional information on the Agencies’ proposed regulations implementing the Volcker Rule is available here. 2. SEC’s Final Rule Amending Definition of “Qualified Client” On February 15, 2012, the SEC adopted its final rule codifying its final order of July 12, 2011 increasing the dollar thresholds of the assets under management and net worth tests in the definition of “qualified client” in Rule 205-3 under the Investment Advisers Act of 1940, as amended (the “Advisers Act”). On that same date, the SEC also adopted final rules amending Rule 205-3 to (i) provide that the SEC will adjust the dollar amount tests for inflation on a five-year basis (as required by the Dodd-Frank Act), (ii) exclude the value of a person’s primary residence from the net worth test, and (iii) add certain transition provisions to Rule 205-3. As amended, the assets under management threshold for qualified clients is $1 million (up from $750,000) and the net worth threshold for qualified clients is $2 million (up from $1.5 million). The revised dollar amounts, which took effect on September 19, 2011, reflect inflation from 1998 to the end of 2010. The first scheduled adjustment to the dollar amount thresholds will take place in 2016. The final rule adopts certain 2 transition provisions, which ensure that the heightened standards for performance fee arrangements apply only to new contractual arrangements, substantially as proposed, and adds an additional provision to allow for limited transfers of interest (e.g., by gift or bequest, or pursuant to an agreement related to a legal separation or divorce) from a qualified client to a person that was not a party to the contract and is not a qualified client at the time of the transfer. The final rule differs from the proposed rule regarding the primary residence exclusion in one respect: under the final rule, any increase in the amount of debt secured by the primary residence in the 60 days before the advisory contract is entered into will be included as a liability. This change is intended to prevent debt that is incurred shortly before entry into an advisory contract from being excluded from the calculation of net worth merely because it is secured by the individual client’s home. The final rule, including the primary residence exclusion and transition provisions, will become effective on May 22, 2012. Additional information on the SEC’s final rule amending the definition of “qualified client” under the Advisers Act is available here. 3. SEC’s Final Rule Revising Definition of “Accredited Investor” On December 21, 2011, the SEC adopted final amendments to its rules to exclude the value of a person’s home from the net worth calculation used to determine whether an individual may invest in certain unregistered securities offerings. The amended rule codifies changes to the definition of “accredited investor” under the Securities Act of 1933, as amended (the “Securities Act”), made effective upon the passage of the Dodd-Frank Act. The final rule differs from the rule proposed by the SEC on January 25, 2011 in three respects: the final rule (i) includes transition provisions which permit the application of the former net worth test for an accredited investor in certain limited circumstances, (ii) treats certain indebtedness secured by the person’s primary residence in the 60 days prior to the sale of securities to that individual as a liability, and (iii) clarifies the language of the proposed rule to make the rule easier to apply. The amended net worth standard became effective on February 27, 2012. The Dodd-Frank Act requires that the SEC review the “accredited investor” standard in its entirety in 2014 and every four years thereafter, and engage in further rulemaking to the extent that it deems appropriate. Additional information on the SEC’s final rule revising the definition of “accredited investor” under the Securities Act is available here. 4. SEC’s and CFTC’s Joint Report on International Swap Regulation On February 1, 2012, the SEC and the CFTC released their Joint Report on International Swap Regulation (the “Joint Report”), as mandated by Section 719(c) of the Dodd-Frank Act. Section 719(c) of the Dodd-Frank Act directs the SEC and the CFTC to study the regulation of swaps, clearinghouses, and clearing agencies in the United States, Europe, and Asia, and to determine similarities and opportunities for harmonizing the regulatory regimes. The Joint Report concluded that it is too early to identify whether there is international alignment in the regulation of over-the-counter (“OTC”) derivatives. The Joint Report also provided recommendations for how the SEC and the CFTC can ensure continued compliance with Section 752(a) of the Dodd-Frank Act, which requires the SEC and the CFTC, as appropriate, to consult and coordinate with foreign regulatory authorities on the establishment of consistent international standards for regulating swaps and swaps entities. The Joint Report recommends that the SEC and the CFTC continue to (i) monitor developments at the national level across jurisdictions, (ii) communicate with fellow regulators involved in efforts to regulate OTC derivatives, (iii) participate in international fora and actively contribute to initiatives designed to develop and establish global standards for OTC derivatives regulation, and (iv) engage in bilateral dialogues with regulatory staff in the European Union, Japan, Hong Kong, Singapore, Canada, and additional jurisdictions, as appropriate. The full text of the Joint Report is available here. 3 5. SEC’s No-Action Letter on Registration of Certain Entities Related to SEC-Registered Investment Advisers On January 18, 2012, the SEC issued a no-action letter (the “2012 Letter”) on various issues regarding the registration with the SEC of certain entities related to SEC-registered investment advisers. The 2012 Letter reaffirms and clarifies the SEC’s position on circumstances under which certain special purpose vehicles (“SPVs”) and certain other advisory or management entities that are related to an SEC-registered investment adviser may satisfy their obligation to register as investment advisers with the SEC through the registration of their related registered adviser. In a December 8, 2005 letter addressed to the American Bar Association’s Subcommittee on Private Investment Entities (the “2005 Letter”),1 the SEC stated that it would not require the registration of an SPV established by a private fund to act as the private fund’s general partner or managing member if certain conditions where met. The 2012 Letter (i) affirmed the continuing validity of the 2005 Letter following the Dodd-Frank Act’s repeal of the private adviser exemption under the Advisers Act; (ii) confirmed that the 2005 Letter applies to registered advisers with multiple SPVs; and (iii) expanded the scope of the 2005 Letter to SPVs with independent directors, provided that such independent directors are the only persons acting on behalf of the SPV who are not “persons associated with” the registered adviser (as defined in Section 202(a)(17) of the Advisers Act). Advisers to a private fund may be part of a group of related advisers for operational, tax, regulatory, or other reasons. The 2012 Letter also addressed the circumstances under which related advisers that are not SPVs (the “relying advisers”) could rely on the registration of a single “filing adviser” in lieu of registering separately with the SEC. The 2012 Letter stated that the SEC would not require relying advisers to file separately from the filing adviser if the filing adviser and each relying adviser collectively conduct a “single advisory business.” Under the 2012 Letter, the SEC would view the filing adviser and one or more relying advisers as a single advisory business if (i) the filing adviser and each relying adviser advise only private funds and separate account clients that are qualified clients (as defined in Rule 205-3 under the Advisers Act) and are otherwise eligible to invest in the private funds advised by the filing adviser or a relying adviser and whose accounts pursue investment objectives and strategies that are substantially similar or otherwise related to those private funds; (ii) each relying adviser, its employees and the persons acting on its behalf are “persons associated with” the filing adviser; (iii) the filing adviser has its principal office and place of business in the United States; (iv) the advisory activities of each relying adviser are subject to the Advisers Act, and each relying adviser is subject to examination by the SEC; (v) the filing adviser and each relying adviser operate under a single code of ethics adopted in accordance with Rule 204A-1 under the Advisers Act, and a single set of written policies and procedures adopted and implemented in accordance with Rule 206(4)-(7) under the Advisers Act and administered by a single chief compliance officer; and (vi) the filing adviser identifies each relying adviser in its Form ADV and discloses that it and its relying advisers are together filing a single Form ADV in reliance of the position expressed in the 2012 Letter. Private equity and real estate advisers with multiple advisory and management affiliates should review the 2012 Letter to determine whether they and their affiliates can be considered a “single advisory business” entitled to rely on the registration of a single filing adviser. Additional information on the SEC’s No-Action Letter is available here. 6. House Members’ Letter Urging the SEC to Delay the Registration Deadline for Exempt Advisers to Private Equity Funds On January 30, 2012, a bipartisan group of twenty-seven Members of the House of Representatives (the “Members”) submitted a letter to SEC Chairwoman Mary Schapiro urging the SEC to delay the March 30, 2012 implementation of the Dodd-Frank Act’s private equity fund adviser registration requirements, and to use its exemptive authority to exclude managers of private equity funds that are not highly leveraged at the fund level from the registration requirements. According to the Members, 4 the SEC’s “registration requirements do not sufficiently consider the nature of private equity funds and the significant differences between private equity and other types of private investment pools.” The Members believe that private equity plays a key role in the country’s economic recovery and that “[s]ubjecting private equity firms to excessive regulation risk is hindering our nation’s economic growth.” A copy of the letter is available here. 7. Director of SEC’s Office of Compliance Inspections and Examinations Outlines Plan for Oversight of Private Fund Advisers On March 9, 2012, Carlo di Florio, director of the SEC’s Office of Compliance Inspections and Examinations (“OCIE”), addressed how OCIE plans to address its new role in the oversight of private fund advisers recently made subject to registration and reporting with the SEC under the Dodd-Frank Act. The statements were made at a conference organized by the Investment Adviser Association in Washington, D.C., and Mr. di Florio stated that he was expressing his own opinions, not necessarily reflecting those of the SEC or its staff. According to Mr. di Florio, OCIE will focus on providing guidance and conducting targeted examinations of private fund advisers. The guidance will highlight OCIE’s expectations as well as effective practices for compliance with the new regulatory requirements. The targeted examinations will focus on what OCIE believes are the key compliance risks facing new registrants, including (among others) fiduciary responsibilities, due diligence practices, “classic” fraud indicators such as aberrational performance, insider trading and front running, and preferential treatment (and related conflicts of interest). According to Mr. di Florio, OCIE intends to focus its examinations on boards and senior management of private fund advisers to ensure that upper management is setting the right tone for compliance. OCIE also intends to engage internal audit personnel, portfolio managers, traders, and front-line business managers to understand “how risk is governed and managed in the firm.” Mr. di Florio does not expect the national examination manual for private fund advisers, modeled after the SEC’s enforcement manual, to be made public until next year. B. Other New and Proposed Securities-Related Legislation and Regulation 1. CFTC’s Final Revisions to the CPO and CTA Registration and Reporting Requirements On February 9, 2012, the CFTC adopted final amendments to its rules relating to commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”) that, among others, rescinds CFTC Regulation 4.13(a)(4), the CFTC exemption from CPO registration commonly relied upon by certain private fund advisers and hedge fund managers. Currently, CFTC Regulation 4.13(a)(4) exempts from CPO registration operators of commodity pools that restrict participation to certain sophisticated investors if certain conditions are satisfied. The final rule retains (with slight modification) the de minimis exemption under Rule 4.13(a)(3), which the CFTC had proposed rescinding. Rule 4.13(a)(3) provides an exemption from CPO registration for operators of commodity pools that have limited futures activity. The revised Rule 4.13(a)(3) will include swaps in the threshold calculation for whether an entity qualifies under the de minimis exemption, pending finalization by the CFTC of the definition of “swap.” In addition, the amended rules now include a requirement that any CPOs or CTAs utilizing the Rule 4.13(a)(3) exemption file an annual notice reaffirming their claims of exemption or exclusion from registration. The amended rules will become effective on April 24, 2012 (the “Effective Amendment Date”). Private fund advisers that are relying on Rule 4.13(a)(4) to avoid CPO registration before the Effective Amendment Date and that have filed the requisite notice with the National Futures Association as of that date will have until December 31, 2012 to identify another exemption or, alternatively, register with the CFTC as CPOs. CPO registration would impose additional financial, disclosure and compliance obligations on advisers and may affect the relevant exemptions or exclusions on which they may rely for the purposes of avoiding registration as a CTA. Advisers should use the transition period to review 5 ... - --nqh--
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